Can Hong Kong Solve Scotland’s Currency ‘Fankle’?

Scottish nationalists are in a quandary: how to dissolve the three-century bond with the United Kingdom while preserving their monetary link with the British pound.

Scottish bank notes.

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And Hong Kong may provide the answer.

Nationalists want to retain the British pound if they win September’s independence vote, but U.K. political leaders ruled out sharing sterling earlier this month. They fear taxpayers would have to back Scotland in times of economic trouble, much as shared use of the euro forced Germany to bail out Greece.

Ditch the union if you want, but say goodbye to sterling, is the message from London.

This creates a bit of a fankle – a Scottish term for a state of disarray , even panic – for the Scottish nationalists. But they may have another card to play.

A currency board could allow Scotland to effectively keep the pound even without consent from the Bank of England, said John Greenwood, the chief economist at Invesco who helped design Hong Kong’s dollar peg, which has held for 31 years.

“If Scotland were to set up a currency board for a Scottish pound that remained at parity (1:1) with the English pound, the trade, current and capital account balances of Scotland would remain broadly unchanged, unless there was some major change in the economic circumstances of either country,” he said in an email.

This arrangement would require sufficient foreign reserves in British pounds to fully cover the amount of currency in circulation and the total held on deposit by commercial banks for interbank clearing transactions. Hong Kong, for example, holds $312.2 billion.

Some naysayers argue it might be hard for Scotland to build up such reserves.

Nomura, in a research report, contends that raising the required amount of reserves could be a “painful” process for Scotland. The bank asks how much of the U.K’s foreign reserves an independent Scotland would be entitled to in the event of a breakup, estimating that a share proportional to the size of the Scottish economy would only provide $4.5 billion, or about 7% of the total reserves needed for a currency board. Scotland may also have to negotiate to draw down its share of the U.K.’s reserves held by the IMF.

A currency board might also make the Scottish pound vulnerable to speculative attack. Defending a currency board against short sellers can be politically painful, said Joseph Yam, a research fellow at the Chinese University of Hong Kong who as chief executive of the Hong Kong Monetary Authority, fought off speculators including George Soros’ Quantum Fund during the Asian Financial Crisis.

“In the case of capital outflow, for whatever reasons, interest rates could rocket to very high levels and severe pain correspondingly inflicted on those shorting the currency as well as the economy; the latter may be so politically unacceptable as to lead to political pressure to abandon the currency board arrangement,” he said in an email.

The Hong Kong Monetary Authority declined to comment on whether it had been consulted over a Scottish currency board.

Britain has been beaten by speculators before. George Soros’ attacks on “Black Wednesday” in 1992 forced the U.K. to break its fixed exchange rate with the precursor of the euro, trashing the economic credibility of the British conservative government, which would spend 13 years out of power.

The Bank of England hiked interest rates from 8.8% to as much as 15% before capitulating. Current Prime Minister David Cameron, then aged 25, worked behind the scenes on the government’s policy response.

Mr. Greenwood agrees that speculative attacks would be possible. However, he said, “if Scotland were to follow the disciplines of Hong Kong in relation to fiscal policy, banking soundness, and the avoidance of leverage then there should be nothing to fear, and the Scottish pound could maintain parity with the English pound.”

Hong Kong defended its peg during the Asian crisis by buying up HK$118 billion of stocks and index futures, a move which later drew praise from Mr. Soros himself.

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